When will housing bottom?

I saw a chart in the european WSJ today on my flight to Berlin that showed housing sales are now lower than they were 20 years ago and with the recession in full swing, it appears they will go even lower.

That begs the question ‘when does it end?’

I’ve always liked to look at rent vs buy analysis to tell me when real estate is fairly valued. Rents can and will go up and down (likely down in this market) but its been my experience that rents, particulalry residential rents, are more stable than residential sale prices.

People need to have a place to live. They can make the choice of rent vs buy, but they have to do one or the other (I know that in tough times there are other scenarios for some on the lower end of the economic spectrum).

If its costs $2000 per month to rent a home for your family and the same home can be bought for $200,000, then it might cost less to purchase the home than rent it.

And even if the bad economy is forcing families to sit on the sidelines because they can’t come up with a down payment, they can’t get a loan, or they think prices will go even lower, there are real estate investors who will step in at some point and buy.

Let’s look at that home you can buy for $200,000 and rent for $2000 per month. If you assume carrying costs (real estate taxes and maintenance) are $6,000 per year, then you can get a net rental income of $18,000 per year on the rental. If you pay $200,000, that’s a 9pcnt yield. But if you can borrow (and that’s an if in the current credit market) $160,000 at 5pcnt per year interest only, then your net rental income is $10,000 per year on an investment of $40,000. That’s a 25pcnt yield.

I think that’s the next leg of the housing market. Smart investors will step in and buy homes and rent them. They’ll probably start in the distressed/foreclosure market so the impact of these buyers coming into the market will not be felt in the traditional real estate market for a while.

But there’s a price where the market clears and I think we may have already reached it in parts of the housing market. A rent vs buy analysis will tell you a lot. When its cheaper to buy than rent by a meaningful amount, then you know the market has overshot and a bottom is near.

I wrote this on my blackberry on the flight to Berlin and I’ve just added a link to the WSJ story (sorry they didn’t put the chart on the web). I apologize for any typos or math errors and if you find any, please point them out in the comments.